Karen Berman

Joe Knight

Explains what business numbers mean and why they matter, and addresses issues that have become more important in recent years, including questions about the financial crisis and accounting literacy.

A Manager's Guide to Knowing What the Numbers Really Mean

Financial Intelligence, Revised Edition

Sagar Rathna Sabapathy

Capital Expenditures: A capital expenditure is the purchase of an item that's considered a long-term investment, such as computer systems and equipment. Most companies follow the rule that any pur- chase over a certain dollar amount counts as a capital expenditure, while anything less is an operating expense. Operating expenses show up on the income statement, and thus reduce profit. Capital expenditures show up on the balance sheet; only the depreciation of a piece of capital equipment appears on the income statement. 

Operating Expenses: Operating expenses are the costs required to keep the business going from day to day. They include salaries, benefits, and insurance costs, among a host of other items. Operating expenses are listed on the in- come statement and are subtracted from revenue to determine profit.

Accruals: An accrual is the portion of a revenue or expense item that is recorded in a particular time span. Product development costs, for instance, are likely to be spread out over several accounting periods, and so a portion of the total cost will be accrued each month. The purpose of accruals is to match costs to revenues ina given time period as accurately as possible.

Allocations: Allocations are apportionments of costs to different departments or activities within a company. For instance, overhead costs such as the CEO's salary are often allocated to the company's operating units.

Depreciation: Depreciation is the method accountants use to allocate the cost of equipment and other assets to the total cost of prod- ucts and services as shown on the income statement. It is based on the same idea as accruals: we want to match as closely as possible the costs of our products and services with what was sold. Most capital investments other than land are depreciated. Accountants attempt to spread the cost of the expenditure over the useful life of the item. There's more about depreciation in parts 2 and 3.

 Goodwill: Goodwill comes into play when one company acquires another company. It is the difference between the net assets acquired (that is, the fair market value of the assets less the assumed liabilities) and the amount of money the acquiring company pays for them. For example, if a company's net assets are valued at $1 million and the acquirer pays $3 million, then goodwill of $2 million goes onto the acquirer's balance sheet. That $2 million reflects all the value that is not reflected in the acquiree's tangible assets- for example, its name, reputation, and so on.

A Balance Sheet The balance sheet reflects the assets, liabilities, and owners' equity at a point in time. In other words, it shows, on a specific day, what the company owned, what it owed, and how much it was worth. The balance sheet is called such because it balances-assets always must equal liabilities plus owners' equity. A finan- cially savvy manager knows that all the financial statements ultimately flow to the balance sheet. We'll explain all these notions in part 3.

The Matching Principle The matching principle is a fundamental accounting rule for preparing an in- come statement. It simply states, "Match the cost with its associated revenue to determine profits in a given period of time usually a month, quarter, or year." In other words, one of the accountants' primary jobs is to figure out and properly record all the costs incurred in generating sales.

THE PURPO0SE OF THE INCOME STATEMENT In principle, the income statement tries to measure whether the prod- ucts or services that a company provides are profitable when everything is added up. It's the accountants best effort to show the sales the company generated during a given time period, the costs incurred in making those sales (incuding the costs of operating the business for that span of time), and the profit, if any, that is left over. Possible bias aside, this is a critically

Different names for the income statement 

The Label Does it say "income statement at the top? It may not. It may instead say "profit and loss statement or P&L statement," operating statement" or "statement of operations," "statement of earnings orearnings statement." All these terms refer to the same document. Often the word consolidated appears as part of the title. If it does, you are probably looking at an income statement for a whole company, with totals for major categories rather than highly detailed line items. ne statement could drive a per-

Financial Intelligence, Revised Edition quotes

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